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Commodity ETFs: Spot and Futures Prices

Key Points

Knowing whether an ETF tracks spot or futures prices will help you better understand its performance.

Futures-based ETFs, the most common structure for commodity ETFs, are subject to contango and backwardation. We'll explain what that means.

One feature many investors like about exchange-traded funds (ETFs) is the ability to access parts of the market that were previously very hard to reach. An example is the commodities asset class—hard to access in the past, but easier now with ETFs. Commodities have their own risks and aren't for everyone, but may be appropriate for investors looking for the opportunity to diversify beyond stocks and bonds.

Commodity ETFs work a bit differently from traditional stock and bond ETFs, though, and it's important to understand the difference before diving in. In order to understand how a commodity ETF works, you'll need to know whether it tracks spot prices or futures prices.

Spot prices and futures prices

The spot price of a commodity is the price that it is trading at right now. If you wanted to buy a barrel of oil or a bushel of corn to take home today, you would pay the spot price. This is the price that you will often see quoted in the news.

The futures price is the price you would pay today for the right to receive the commodity at some point in the future (say, three months from today). With a futures contract, you're locking in a price today rather than waiting to see what the spot price will be at some point in the future and then making the purchase at that price.

Physical ETFs vs. futures-based ETFs

Some ETFs hold the physical commodity itself. This is most common with precious metals such as gold and silver, because storing the commodity is fairly straightforward: Buy bullion and put it in a vault.

If your ETF holds the physical commodity, the value of your ETF shares will move with the spot price of the commodity, though the price could also be affected by security issues around storing the physical commodity itself.

Other ETFs hold baskets of futures contracts and never take possession of the physical commodity. This is the most common commodity ETF structure, whether it's for oil, agricultural commodities, broad baskets of commodities or even some precious metal ETFs. Storing oil or wheat is more difficult than storing bullion, which is why these ETFs don't just hold the physical goods.

If an ETF holds futures contracts, it will have to roll those contracts whenever they get close to expiration. This means that as the maturity date of the futures contract gets close (that is, the contract the ETF bought three months ago is getting close to the date on which the commodity is to be delivered), the ETF manager will sell the contract that is ready to expire and buy new contracts for a future date.

The impact on the ETF's returns from this continuous process of selling expiring contracts and buying longer-dated contracts is called roll yield.

Contango and backwardation

Sometimes, roll yield can be positive. Imagine a market where the people who are buying and selling futures contracts expect the future price of the commodity to be lower than it is today.

Maybe the spot price is $50, but the futures price in three months is only $48. If you buy contracts for $48 but the price remains at $50, you'll be able to sell those contracts for close to $50 when they're getting close to maturity, and replace them with longer-dated contracts for $48. The roll yield would be positive because you're constantly buying at a lower price and selling at a higher price.

A market in which the futures price is lower than the spot price is said to be in backwardation. Historically, many commodities have tended to trade this way, and for those commodities, this is known as normal backwardation.

On the other hand, the roll yield could be negative. Imagine the reverse of the situation described above. Let's say that the commodity's spot price is currently $50, but three-month futures contracts are trading at $52. If the relationship remains steady over time, you would be selling your maturing contracts for $50 and paying $52 to replace them with new three-month contracts.

Such a market, where the futures price is higher than the spot price, is said to be in contango. Oil markets, for instance, have often been in contango in recent years.

How does contango affect your ETF? An ETF that holds futures contracts is going to have worse returns than the physical commodity if the market remains in contango (and better returns if the market is in backwardation).

Every time the ETF manager rolls the futures contracts (selling the expiring contracts and buying longer-dated contracts), the ETF is losing money. The steeper the contango, the worse the relative return on the rolling futures contracts compared to the spot price of the commodity.

In a nutshell, the risk with a futures-based ETF is that contango could erode returns.

What to do?

So what can you do about this? First, always keep in mind that the process works in investors' favor if the market for a commodity is in backwardation. However, if the market is in contango, there are a few things to consider:

ETFs that hold a physical commodity are not subject to contango (though such ETFs aren't available for every commodity).

An ETF that spreads its assets among shorter- and longer-dated futures contracts will roll less of its portfolio each month, therefore lessening the impact of contango.

Certain ETFs are constructed specifically to avoid the negative impact of contango (or to take advantage of the positive impact of backwardation) by tracking indexes that select futures contracts with the most favorable roll yield.

Investing in products that use commodity futures contracts requires a basic understanding of contango and backwardation. With some careful research, you can choose products that suit your investing strategy and your views on the direction of the market.

How can I tell the difference between a physical ETF and a futures-based ETF?

by the Schwab Center for Financial Research

Schwab clients can log in to access our ETF research center. Once there, enter the name or ticker symbol of the ETF you're interested in and click Research.

Within the Summary box, you should see a Fund Strategy section that explains what the fund invests in. If it describes buying and selling a commodity (common with certain gold and silver ETFs), it's a physical ETF and should move with spot prices. If it describes using futures contracts, it will move with futures prices and be subject to the effects of contango and backwardation.

For a complete description of an ETF's strategy, be sure to read the prospectus.

Investors should consider carefully information contained in the prospectus, including investment objectives, risks, charges and expenses. You can request a prospectus by calling Schwab at 800-435-4000. Please read the prospectus carefully before investing.

Some specialized exchange-traded funds can be subject to additional market risks. Investment returns will fluctuate and are subject to market volatility, so that an investor's shares, when redeemed or sold, may be worth more or less than their original cost.

Since sector- and commodity-specific funds are not diversified and focus their investments entirely in a single sector, commodity, or basket of commodities, the funds will involve a greater degree of risk than an investment in other diversified fund types.

Commodity-related products, including futures, carry a high level of risk and are not suitable for all investors. Commodity-related products may be extremely volatile, illiquid and can be significantly affected by underlying commodity prices, world events, import controls, worldwide competition, government regulations, and economic conditions, regardless of the length of time shares are held. Investments in commodity-related products may subject the fund to significantly greater volatility than investments in traditional securities and involve substantial risks, including risk of loss of a significant portion of their principal value. Commodity-related products are also subject to unique tax implications such as additional tax forms and potentially higher tax rates on certain ETFs.

This article is for informational purposes only and is not an offer, solicitation or recommendation that any particular investor should purchase or sell any particular security or pursue a particular investment strategy. The types of securities mentioned herein may not be suitable for everyone. Each investor needs to review a security transaction for his or her own particular situation. All expressions of opinion are subject to change without notice in reaction to shifting market conditions.

This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner or investment manager.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

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